Chapter 1 Introduction: What This Book is About

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Chapter 1 – Take Aways

 Problem solving requires two steps:  You identify profitable decisions  You figure out how to implement them  The rational-actor paradigm assumes that people act rationally, optimally, and self interestedly. To change behavior, you have to change people’s view of what’s in their own self-interests by changing incentives.

 A well-designed organization is one in which employee incentives are aligned with organizational goals.

 Good incentives are created by rewarding good performance.

 You can analyze any problem by asking three questions:  Who is making the bad decision?   Do the decision makers have enough information to make a good decision? Do the decision makers have incentives to make a good decision?

Introductory Anecdote: Oil Bidding

     Young geologist preparing bid recommendation for Golf of Mexico oil tract With knowledge of productivity of neighboring tract also owned by company, geologist recommended bid of $5 million Senior management bid $20 million, beating out next highest bid of $750,000 How would you go about solving this problem?

The goal of this text is to provide tools to help diagnose and solve problems like this 3

Course Goals

  Show you how to identify profitable decisions  By using benefit-cost analysis Then ensure that they are made in your organization  Make sure employees have the

information

necessary to make good decisions  And the

incentive

to do so 4

Solving Problems

 Two issues  What’s wrong?

 How can we fix it?

 Requires predicting human behavior  Economists utilize the rational-actor paradigm 5

Methodology: Rational Actor Paradigm

 The one thing that unites economists is rational actor paradigm  People behave optimally, rationally, selfishly  To change behavior, you change incentives.

 Use paradigm to predict behavior  Identify profitable decisions  Using benefit-cost analysis  And then implement them  Using “organizational architecture” 6

Analyzing Overbidding

    Another piece of the story    After winning the bid, geologist increased estimated reserves of company But, after a dry well was drilled, reserve estimates were decreased Executive stepped in and order increase to reserve estimate Why were executives so interested in estimated reserves? Think about incentives!

It turns out that executive bonuses were tied to increasing the amount of estimated reserves.

Senior management resigned several months later collecting sizeable bonuses tied to the “great job” they had done increasing the reserves of the company 7

Fixing the Problem

 Need to align the incentives of executives with the goals of the company  Easy to say but often hard to do  In general, bad decisions are made for two reasons:  Poor incentives  Poor information 8

Questions to Diagnose and Solve Problems

 Ask three simple questions to diagnose the problem    Who is making the bad decision?

Do they have enough information to make a good decision?

Do they have an incentive to make a good decision?

 Answers suggest potential solution paths   Let someone else make the decision (someone with better info or incentives) Give more information to the current decision maker  Change the incentives of the decision maker 9

Ethics

 Do we encourage self-interested, selfish behavior by using the rational-actor paradigm?

 Opportunistic behavior is a fact of life  You need to understand how to recognize it to protect yourself against it  The rational-actor paradigm is a tool, not a prescription 10

Ethics

 Do we encourage self-interested, selfish behavior by using the rational-actor paradigm?

 Opportunistic behavior is a fact of life  You need to understand how to recognize it to protect yourself against it  The rational-actor paradigm is a tool, not a prescription 11

Why Else This Material is Important

 Employers expect that you will know these concepts  And, be able to apply them 12

Ethics

   Economists often also share an assumption that the goal of the firm is profit maximization Opinions do differ, however   Discussion: pricing of hotel rooms during home football game weekends  Traditional economic view – level pricing leads to excess demand; how are rooms allocated then (rationing, arbitrageurs, . . .)?

 Contrasting view – businesses should not raise prices during times of shortage; businesses have a responsibility to consumers and society Your view?

Text view: firms serve consumers and society best by engaging in free and open competition within legal limits while attempting to maximize profits.    Not a license to engage in illegal behavior No denying that concerns exist about the ethical dimension of business Reasonable people have disagreed for millennia on what constitutes “ethical” behavior 13

Alternate Intro Anecdote

   Joseph Jett was a star bond trader for Kidder Peabody in the early 90’s, earning multi-million dollar annual bonuses Traded “strips” – separating interest payments from government bonds and then putting back interest payments with the stripped bonds  Earns profit by taking advantage of yield differences between zero-coupon bonds and interest-bearing bonds But, Jett made profit regardless of yield differences??

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Jett Anecdote (Part 2)

     KP computer systems were not designed to handle this kind of trading Although these were 5-day forward contracts, profits were recognized immediately (equal to five days interest); even though by day of settling, profits would be zero.

By continuously increasing size of contracts, profits continued to accrue Jett and his supervisor rewarded with large bonuses The moral   People respond to incentives Make sure your tracking systems are adequate to ensure the behavior being rewarded is truly what you want 15

Extra Discussion

   Why do seat belts kill?

 What does this say about rational actor paradigm?

Why does Landsburg say that “Taxes are bad only if you can avoid them?” Is the rational actor paradigm a narrow view of the world?

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